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17
Macroeconomic Policy Debates
Chapter Summary
As a student and citizen, you are inevitably drawn into economic debates. In most cases, the debates are
complex, because they involve a mixture of facts, theories, and opinions. Value judgments play a large
role in economic debates. In previous chapters, you learned the basic vocabulary of economics and
studied different theories of the economy. Now you are ready to examine some of the key policy issues in
macroeconomics. Here are the main points of the chapter:
 A deficit is the difference between the government’s current expenditures and revenue. The
government debt is the sum of all past yearly deficits.
 Deficits can be financed through either borrowing or money creation. Financing deficits through
money creation is called monetizing the deficit. It leads to inflation.
 Deficits can be good for the country. Automatic stabilizers and expansionary fiscal policy both
work through the creation of deficits.
 The national debt incurs two burdens on citizens: It can reduce the amount of capital in an
economy, leading to lower levels of income; it can also result in higher taxes that future
generations will have to pay.
 A number of developed countries have recently changed their monetary policy to emphasize
targeting the inflation rate or a range for the inflation rate.
 Although targeting inflation can increase the credibility of a central bank, it does limit the tools
left for active stabilization policy.
 A consumption tax would increase the incentives for private saving. However, it is not clear that
total savings would necessarily increase, and there would be concerns about the fairness of this
form of taxation.
Applying the Concepts
After reading this chapter, you should be able to answer these three key questions:
1. What are the long-term fiscal imbalances for the United States?
2. Should central banks pay special attention to asset prices – such as stock prices, housing prices, or
exchange rates – as they determine monetary policy?
3. What did the most recent federal tax reform commission suggest as the most appropriate
directions for reform?
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 Study Tip
This chapter deals with macroeconomic issues. This is a chance to apply concepts you
learned in previous chapters. If you have forgotten some of the key terms, review them
from previous chapters. Also, look for both sides of the issues. Find the pros and cons of
the issue.
17.1 Should We Balance the Federal Budget?
To balance a budget, we need to review some terms from Chapter 10. Government expenditures
include goods and services purchased by the government and transfer payments, such as Social Security
and welfare, made to citizens. A surplus occurs when the government’s revenues exceed its expenditures
in a given year. The government runs a deficit when it spends more than it receives in revenues from
either taxes or fees in a given year.
 Caution!
Many people confuse the debt and deficits. Remember that the deficit is when the
government spends more than it takes in revenue for a fiscal year. The government debt is
the total of all yearly deficits over time.
The government debt is the total of all its yearly deficits. For example, if a government initially had a
debt of $100 billion and then ran deficits of $20 billion the next year, $30 billion the year after that, and
$50 billion during the third year, its total debt at the end of the third year would be $200 billion.
 Caution!
In this chapter, we focus on the debt held by the public, not the total federal debt, which
includes debt held by other governmental agencies. Sometimes popular accounts in the
press or on the Web highlight the total federal debt. However, the debt held by the public is
the best measure to assess the burden that the federal debt can have on the economy.
 Go to the following Web sites for the latest information about the national debt:


www.publicdebt.treas.gov/
www.brillig.com/debt_clock
The Budget in Recent Decades
Beginning in the 1980s and through most of the 1990s, the federal budget ran large deficits—“deficits as
far as the eye can see,” as David Stockman, the director of the Office of Management and Budget in
President Reagan’s administration, put it. Yet in fiscal year 1998, during President Clinton’s
administration, the federal government ran a budget surplus of $69 billion—its first surplus in 30 years. It
continued to run surpluses for the next three fiscal years as well. What caused the change?
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The surplus emerged for two key reasons:
1. Economic growth was very rapid and tax revenues—including tax revenues from the sales of
stocks and bonds—grew more quickly than anticipated.
2. Federal budget rules were in place that limited total spending.
When President George W. Bush took office in January 2001, the large surplus led him to propose substantial
tax cuts. Bush and Congress then passed a 10-year tax cut amounting to $1.35 billion over the course of the
decade. Although the tax cuts were large, the Congressional Budget Office (CBO) estimated at that time that
the federal government would nonetheless continue to run surpluses through 2010.
Figure 17.1 depicts the debt-to-GDP ratio from 1791 to 2007. Notice, except for the period in the 1980s,
the ratio rises sharply during wars and falls during peacetime. With neither a war nor a recession looming
on the horizon in early 2001, the CBO predicted the debt-GDP ratio would be relatively low by the end of
the decade.
Unfortunately, a series of events intervened to bring deficits back into the picture. The Bush tax cuts,
collapse of the stock market, the recession that began in 2001, the downturn in housing in mid-decade,
and the recession beginning in December 2007 all sharply reduced tax revenues. Additional tax cuts
subsequently passed to stimulate the economy added to the deficit. The fight against terrorism led to
higher spending on homeland security and military spending as wars were launched in Afghanistan and
Iraq. The federal government ran a budget deficit of $455 billion in fiscal year 2008, a far cry from
surpluses in the late 1990s. Aggressive economic stimulus plans and federal spending to deal with the
financial distress that emerged after the housing crisis will increase the deficit even further in subsequent
years.
The Budget and Social Security
Federal budget figures include revenue and expenditures from the Social Security system. Over the next
decade, the Social Security portion of the budget is expected to run a surplus because of the huge number
of baby boomers, those born between 1946 and 1964, currently paying taxes into the system. That
surplus won’t last forever, though. Some economists argue that Social Security funds should not be
included in federal budget figures because the money will be needed to make future Social Security
payments to these baby boomers. Over the longer horizon, the surpluses in the Social Security account
will disappear and turn to deficits. As our society grows older, spending on both Social Security and
Medicare will increase. That increase in spending is causing the CBO to predict emerging federal deficits
and sharp increases in the debt/GDP ratio to levels comparable to World War II, unless taxes are raised
and/or spending is cut significantly.
Five Debates about Deficits
As we have seen, federal budgets are affected by a wide range of factors, including wars, demographic
pressures, recessions, and the choices our politicians make on spending and taxes. But what principles
should policy makers use to make decisions about cutting and raising taxes and evaluating the national
debt? Let’s take a look at the debates over the national debt.
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Debate One: Do Deficits Lead to Inflation?
In the United States, the Treasury Department issues government bonds to finance the deficit. The Federal
Reserve has the option of buying existing government bonds, including those newly issued by the
Treasury Department. If the Federal Reserve does purchase the government’s bonds, the purchase creates
money by taking debt out of the hands of the public in exchange for money. Economists call the purchase
by a central bank of newly issued government debt monetizing the deficit. If governments finance
deficits by creating new money, the result will be inflation.
Debate Two: Is Government Debt a Burden on Future Generations?
The national debt, another commonly used term for total government debt, can impose two different
burdens on society, both of which fall on the shoulders of future generations. First, a large debt can
reduce the amount of capital in the economy and thereby reduce future income and real wages for its
citizens. The result of government deficits is that less savings are available to firms for investment. This
illustrates one of our basic principles in economics.
Principle of Opportunity Cost
The opportunity cost of something is what you sacrifice to get it.
Reduced saving and investment will ultimately reduce the stock of private capital. As a result, there will
be less capital deepening. With lower capital per worker, real incomes and real wages will be lower than
they otherwise might have been. The government deficit comes at a cost in the future. Second, a large
national debt will mean that higher taxes will be imposed on future generations to pay the interest that
accumulates on the debt. More income is used to pay the interest on the debt than in more productive
purposes. Just like your college loans, the bill eventually comes due—even for the national debt.
Sometimes you hear that these interest payments are not a real burden because “we owe the national debt
to ourselves.” This is a misleading argument for several reasons. First, we don’t owe the interest
payments only to ourselves. In 2008, approximately 53 percent of U.S. public debt was held by
foreigners. Second, a high proportion of the debt is held by older, wealthy individuals or by institutions,
but the taxes levied to service it will be paid by everyone in the United States. Some economists do not
believe that government deficits, resulting in government debt, impose a burden on a society. These
economists believe in Ricardian equivalence, the proposition that it does not matter whether government
expenditure is financed by taxes or financed by issuing debt.
Consider the following example. A government initially has a balanced budget. It then cuts taxes and
issues new debt to finance the deficit left by the reduction in taxes. Everyone understands that the
government will have to raise taxes in the future to service the debt, so everyone increases savings to pay
for the taxes that will be increased in the future. If saving rises sufficiently, the public—everyone—will
be able to purchase the new debt without reducing the funds they invest in the private sector. Because net
investment doesn’t decline, there will be no debt burden. As you can see, Ricardian equivalence requires
that savings by the private sector increase when the deficit increases. Do savers behave this way? It is
actually difficult to provide a definite answer because many other factors must be taken into account in
any empirical studies of savings. It appears, however, that during the early 1980s, savings decreased
somewhat when government deficits increased. This is precisely opposite to what Ricardian equivalence
predicts. As long as Ricardian equivalence does not fully hold true, it’s reasonable to assume the
government debt imposes a burden on society.
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Debate Three: How Do Deficits Affect the Size of Government?
Nobel laureate James Buchanan has argued that people are less aware of government deficits than the taxes
they’re forced to pay. Therefore, financing government expenditures through deficits, rather than through
higher taxes, will inevitably lead to higher government spending and bigger government. Buchanan’s
argument does not hold true for two reasons. First, in recent U.S. history, spending by state and local
governments has grown much faster than federal spending. However, state and local governments face
many more restrictions when it comes to borrowing money than the federal government faces. For example,
many states require legislators to run a balanced budget. Deficit spending isn’t allowed.
 Many state budgets are divided into two budgets, an operating budget and a capital budget.
States
often require the operating budget to be balanced, while the capital budget can be financed with bond
financing. The federal budget is an omnibus budget, meaning that all spending, operating and capital
spending come under one budget. Many states would have deficits if they used an omnibus budget like
the federal government.
Second, if Buchanan’s argument were true, why did the federal government run surpluses in the late
1990s if politicians trying to get reelected prefer higher government spending and deficits to higher taxes
and surpluses? More recent thinking suggests that deficits can be used strategically to actually reduce the
growth of government. During the 1980s, for example, the government ran large deficits caused by a
combination of a deep recession and major tax cuts. The deficits subsequently made it difficult for
politicians to propose new spending programs. Proponents of smaller government, therefore, may wish to
cut taxes to reduce surpluses or increase deficits in order to make it more difficult for other politicians to
increase government spending. These deficit proponents want to create deficits to prevent “putting sand in
Congress’s sandbox.” Some Congressmen supported President Bush’s tax cut in 2001, which reduced the
surplus over a 10-year period, precisely for this reason.
Debate Four: Can Deficits Be Good for an Economy?
Deficits automatically emerge during recessions, which also stabilize the economy. Recall how automatic
stabilizers work. As incomes fall during a recession, so do tax payments. Moreover, transfer payments
such as welfare and food stamps rise. Because government spending increases while tax revenues fall,
the deficit must, of course, rise. However, a rising deficit may be what it takes to steer the economy back
to full employment.
Professor Robert Barro of Harvard University has argued that it is more efficient to keep tax rates
relatively constant than to raise them sharply and then lower them later. Temporarily raising tax rates to
very high levels could cause distortions in economic behavior that we would like to avoid. Thus, by
running deficits and only gradually raising taxes later to service the debt, we avoid creating excess
distortions in the economy.
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Let’s review an Application that answers one of the key questions we posed at the start of the chapter:
1. What are the long-term fiscal imbalances for the United States?
APPLICATION 1: NEW METHODS TO MEASURE THE LONG-TERM FISCAL
IMBALANCES FOR THE UNITED STATES
Over time, there will be an escalating gap between revenues and expenditures, which would have to
be met by outright borrowing. How can we measure the size of the gap? Economists Jagadeesh
Gokhale of the Cato Institute and Kent Smetters of the University of Pennsylvania have developed a
more comprehensive measure of a nation’s indebtedness. The method includes estimating the
present value of the gap between the government’s revenues and expenditures and adding it to the
current national debt. This new total measure, which Gokhale and Smetters call the “fiscal
imbalance,” was calculated in 2003 to be approximately $44 trillion, or four times GDP. This is a
huge number. Even during World War II, government debt was only 1.2 times GDP. Gokhale and
Smetters estimate that about 80 percent of the fiscal imbalance will stem from Medicare—rising
health-care costs for the elderly. What these numbers suggest is that our current health-care system
for retirees will need to undergo fundamental reform to make it more sustainable.
Debate Five: Would a Balanced-Budget Amendment Really Work?
How would a balanced-budget amendment actually work? Many different budgetary Constitutional
amendments have been proposed. They all require that, after a phase-in period, Congress propose in each
fiscal year a budget in which total revenues (excluding borrowing) cover total expenditures. The
amendments also have various escape clauses—for example, to allow borrowing during wartime. Some
amendments also allow Congress to suspend the requirement to balance the budget for other reasons, such
as during a recession when deficits naturally emerge. Finally, some versions of the amendment would
limit the rate of spending increases to the rate at which GDP is growing.
Proponents of the balanced-budget amendment say that it will finally exert discipline on the federal
government, preventing large deficits in peacetime, such as those that occurred in the 1980s. With a
balanced budget, we could be sure to avoid the effects of deficits: reduced capital formation and shifting
tax burdens onto future generations.
Critics of a balanced-budget amendment point to many different problems, such as the following:
 A balanced budget may not allow enough flexibility, or room, for the government to effectively
deal with recessions. Under some versions of the amendment, unless three-fifths of Congress
votes to suspend requirements, the government would have to cut expenditures or raise taxes
during a recession. This would make the recession worse and limit the ability of the government
to use fiscal policy to stabilize the economy.
 The Constitution is not the right mechanism to try to enforce complicated budget rules. As
various interested parties challenge the actions of Congress, the courts would become heavily
involved in federal budget matters.
 Congress could devise special budgets to get around the requirement, for example, by taking
some types of spending “off budget,” which means simply not counting them as part of the
official budget.
 Congress could also find nonbudgetary ways to carry out the policies that it desires. For example,
it could issue more regulations or impose mandates or requirements on businesses or other
governments to carry out its will. These regulations or mandates could be even more costly to the
economy than added deficits.
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17.2 Should the Fed Target Inflation?
In Chapter 6, we examined some of the costs of inflation, which include the following:
 Menu costs—the costs firms incur to change their posted prices.
 Shoe-leather costs—the costs individuals and firms pay for the time and resources they spend
trying to reduce their holdings of money.
 Distortions in our tax and banking systems because inflation isn’t yet factored into them.
 Arbitrary redistributions of money between debtors and creditors from unanticipated inflation.
Debate One: Should the Fed Focus Only on Inflation?
Proponents of inflation targeting argue that the Fed should have only one primary goal: controlling
inflation. Other proponents of inflation targeting hold a somewhat less rigid view. Although these
proponents believe fighting inflation should be the primary objective of the Fed, or a central bank, they
believe an inflation-targeting regimen could be designed to give the central bank some flexibility. For
example, the central bank could be required to target a broader range of inflation—say, between 1 and 3
percent—and meet the target several years in the future. This position is consistent with the views of the
current chairman of the Federal Reserve, Ben Bernanke.
If monetary policy is geared solely toward controlling inflation, as inflation-targeting proponents would
like, and fiscal policies are difficult for Congress and the president to pass, that leaves the government no
other tools to fight a recession. Economists also debate the level for an inflation target. Suppose there
were general agreement that the ultimate goal should be total price stability—that is, zero inflation. There
would still be legitimate questions about what constitutes “stable” prices. Some economists like the idea
of the Fed having to meet targets, but they have suggested alternatives to inflation targeting. One
alternative would be for the Fed to target the growth rate in nominal GDP instead of inflation. Critics of
stabilization policy, of course, believe that not using monetary policy to try to stabilize the economy
would actually improve our economic performance.
Let’s review an Application that answers one of the key questions we posed at the start of the chapter:
2. Should central banks pay special attention to asset prices – such as stock prices, housing prices, or
exchange rates – as they determine monetary policy?
APPLICATION 2: SHOULD CENTRAL BANKS TARGET ASSET PRICES?
Some economists believe central banks should pay much more attention to the prices of assets as
they formulate monetary policy. Recent recessions in Japan and the United States were caused by
problems in the financial and real estate markets. Should the central bank have done more to
prevent the speculative excesses or bubbles in the stock and housing markets in Japan and the
United States? The conventional wisdom of central bankers is that information about asset prices
should be considered only as it affects forecasts of inflation or output. In particular, interest rates
should not be raised to “prick” any speculative bubbles. According to this view, bubbles are hard
to identify, the effects of interest rates on bubbles are uncertain, and there are many different asset
prices that a central bank would have to watch. Still, critics say the Fed was too slow to raise
interest rates in 2003 and 2004 and let the housing bubble develop in the United States. If it had
been watching that market more carefully, it could have raised interest rates and perhaps offset
some of the damage done by the rise and fall in housing prices.
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Debate Two: If There Were an Inflation Target, Who Would Set It?
In the United Kingdom, which adopted inflation targeting in 1992, the elected government decides on the
inflation target for the central bank. These elected officials typically specify a range for the inflation rate
that the bank must meet. The central bank is heavily involved in the discussions and has an opportunity to
present its views to the public through its publications and published minutes of its meetings. But
ultimately, it is the elected government that makes the final decision. In other countries, the central bank
has even more influence in setting the inflation target. In New Zealand, for example, the central bank has
the responsibility of “achieving and maintaining stability in the general level of prices” without any
competing goals, such as stabilizing employment or output. Under current law in the United States, the
Fed chairman reports regularly to Congress, but the Fed has considerable power to use monetary policy to
stabilize output as well as to fight inflation as it pleases.
17.3 Should We Tax Consumption Rather Than Income?
The U.S. tax system discourages savings. Here’s how. In the United States, you must pay taxes on both
the wages you earn and the interest you earn on your savings. Suppose that you earn $100 at your job and
you have a tax rate of 20 percent. That means you keep $80 after taxes. Now suppose that you save $50 of
that money and invest it at 10 percent. At the end of one year, you will have earned an additional $5 on
earned in wages, plus $1 on the $5 you earned on your savings. If you did not save at all, you would pay
only $20 in taxes, not $21.
Not all tax systems work this way. Consumption tax systems do not penalize individuals who save. Sales
taxes in the United States and value added taxes abroad are familiar examples of consumption taxes. It is
also possible to create a consumption tax from an income tax by not taxing the earnings on savings—just
as we do with tax-exempt bonds issued by state and municipal governments. Or, as an alternative, the
government could allow savings to be deducted from gross income before the calculation for total taxes
owed is made. The key feature of consumption taxation is that you do not face any additional taxes if you
decide to save more of your income.
Debate One: Will Consumption Taxes Lead to More Savings?
Taxing consumption instead of savings creates an incentive to save. However, there’s no guarantee the
incentive will actually result in more money saved in the economy. The tax system imposed on
corporations in the United States also creates disincentives to save and invest. Suppose you purchase a
share of stock in a corporation. When the corporation earns a profit, it pays taxes on the profit at the
corporate tax rate. When the corporation pays you a dividend on the stock out of the profits it earns, you
must pay taxes on the dividend income that you receive. Corporate income is taxed twice, in other
words—first when it is earned by the corporation and again when it is paid out to shareholders.
Some economists have argued that the corporate taxes lead to less-efficient investment because they result
in capital flowing into other sectors of the economy (into real estate, for example) that do not suffer from
double taxation. For this reason, in 2003 Congress passed a bill introduced by President Bush that
lowered—but did not eliminate— taxes on corporate dividends.
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Debate Two: Are Consumption Taxes Fair?
The basic idea behind a consumption tax seems fair. Individuals should be taxed on what they consume—
not on what they actually produce. However, moving to a consumption-tax system could clearly favor
wealthy and high-income individuals who save the most and earn a lot of income in interest, dividends,
rents, and capital gains. Table 17.1 shows estimates based on the capital gains received by different
income classes for the year 2003. Capital gains are the profits investors earn when they sell stocks,
bonds, real estate, or other assets. As you can see, taxpayers with annual incomes exceeding $500,000
earned over half of the economy’s capital gains over this period. Obviously, capital assets are highly
concentrated among the wealthy. If capital gains and other types of capital income were not taxed, total
tax revenue would fall, and the government would have to raise tax rates on everyone to maintain the
same level of spending. Excluding capital income from taxation does have its costs. The tax system is
one way we have to at least partially reduce inequalities in income.
Critics of consumption taxes worry that moving our tax system in that direction will take away this
important tool for social equality. However, other economists believe that high-income individuals
already shoulder a very high share of the total tax burden and that we need to focus on designing an
efficient system to promote economic growth.
Let’s review an Application that answers one of the key questions we posed at the start of the chapter:
3. What did the most recent federal tax reform commission suggest as the most appropriate
directions for reform?
APPLICATION 3: TWO DIFFERENT DIRECTIONS FOR TAX REFORM
In 2005, the President’s Advisory Panel on Federal Tax Reform published its report “Simple, Fair
and Pro-Growth.” The panel proposed two different proposals for consideration, one based on
income tax principles and the other based on consumption tax principles. Both plans had several
features in common. They lowered tax rates by broadening the tax base and they reduced taxes on
investment income. Under the income tax version, individuals would no longer pay taxes on
dividends from U.S. firms but they still would pay some taxes on capital gains. The consumption
tax plan allows deductions for wages, material costs, and investment spending. However, the
panel was sensitive to concerns about fairness. To ensure that wealthy individuals still paid some
taxes, the plan levied a tax on dividends and capital gains received by individuals. The plans were
not enacted into legislation but will be the source of many excellent tax reform ideas for the
future.
This version of the flat tax has an important feature that ensures that wealthy individuals still pay
taxes. Suppose the corporation or business makes an extraordinary return on its investment. Under
this version of the flat tax, these extraordinary gains would be taxed in full. Owners of a corporation
or business may earn extraordinary gains, but if they do, they will pay taxes on these gains.

According to James Arnold, a BBC business news reporter, more eastern European countries are
adopting flat tax systems than western European countries. Many eastern European countries were trying
to avoid huge tax evasion by using a flat tax system. Visit the BBC Web site at
http://news.bbc.co.uk/2/hi/business/4444717.stm for more details.
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Activity
You have learned about inflation targeting. As with the many debates in this chapter, there are two sides
to the argument. One question in the debate is, “Should the Fed Focus Only on Inflation?” List one “yes”
reason and one “no” reason.
Answer
Some of your answers may include the following:
Debate One: Should the Fed Focus Only on Inflation?
Pro or yes:
 Worrying about other factors—unemployment or the exchange rate—will distract the Fed from
its mission and lead to long-run inflationary pressures building in the economy.
 Having a single focus would give the Fed more credibility.
Con or no:
 Monetary policy is useful for fighting recessions. If the Fed is focused on inflation only,
stabilization policy would be hindered.
 It is difficult to measure price stability, especially to a specific target.
Key Terms
Capital gains: Profits investors earn when they sell stocks, bonds, real estate, or other assets.
Consumption taxes: Taxes based on the consumption, not the income, of individuals.
Monetizing the deficit: Purchases by a central bank of newly issued government bonds.
Ricardian equivalence: The proposition that it does not matter whether government expenditure is
financed by taxes or debt.
Practice Quiz
(Answers are provided at the end of the Practice Quiz.)
1. Which of the following is considered a government expenditure?
a. the purchase of goods and services by the government
b. transfer payments
c. Social Security and welfare payments
d. all of the above
2. The government debt is defined as
a. the excess of total revenues over total expenditures.
b. the excess of total expenditures over total revenues.
c. government spending on goods and services plus transfer payments.
d. the sum of all past deficits.
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3. Over the next decade and beyond, the Social Security portion of the federal budget is expected to
a. run a deficit for a while, but then the deficits will turn to surpluses.
b. run a surplus for a while, but then the surpluses will turn to deficits.
c. continuously run deficits.
d. continuously run surpluses.
4. Which of the following equalities is correct?
a. government deficit = government spending – transfer payments
b. government deficit = taxes – transfer payments
c. government deficit = new borrowing from the public + new money created
d. government deficit = accumulated government debt year after year
5. Monetizing the deficit refers to
a. adjusting exchange rates to reduce federal expenditures.
b. converting the deficit to cash.
c. printing money to pay the federal deficit.
d. purchases by a central bank of newly issued government debt.
6. Suppose the government’s initial debt is $375 billion. If for the next three years the government runs
deficits of $75, $125, and $100 billion, the government’s total debt at the end of the three years will
be
a. $375 billion.
b. $75 billion
c. $675 billion.
d. $300 billion.
7. Ricardian equivalence is the proposition that
a. government expenditure should only be financed by taxes.
b. it does not matter whether government expenditure is financed by creating new money or by
issuing debt.
c. it does not matter whether government expenditure is financed by taxes or debt.
d. government expenditure should only be financed by issuing new debt.
8. According to Nobel laureate James Buchanan, people are
a. less aware of government deficits than the taxes they’re forced to pay.
b. highly aware of government deficits, and this will prevent government from spending out of
control.
c. largely indifferent about taxation and government spending.
d. usually unaware of tax increases.
9. Which of the following statements is correct?
a. Over short periods, deficits can help the economy to cope with shocks.
b. Deficits can give government some room to maneuver out of a recession.
c. Deficits can play a role in tax smoothing.
d. all of the above
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10. This question tests your understanding of Application 1 in this chapter: The long-term fiscal
imbalances for the United States. What are the long-term fiscal imbalances for the United States?
To determine the gap between revenues and expenditures, economists Jagadeesh Gokhale and Kent
Smetters developed a method which consists of
a. estimating the present value of the gap between the government’s revenues and expenditures and
adding it to the current national debt.
b. finding the “fiscal balance,” or the level of revenues necessary to match the level of expenditures
in a given year.
c. adding the yearly value of the debt each year to come up with an estimate of the national deficit.
d. finding the fiscal deficit, however, because the fiscal gap is so small, an estimate of budget deficit
projections could not be found.
11. Which of the following is a cost of inflation?
a. menu costs
b. shoe-leather costs
c. arbitrary redistributions of money between debtors and creditors
d. All of the above are costs of inflation.
12. Which of the following reflects the growth in real GDP as well as the growth in prices?
a. the growth rate in nominal GDP
b. the growth in real GDP
c. the growth of the money supply
d. the inflation target
13. In which of the following countries does the government decide on the inflation target for the central
bank?
a. United Kingdom
b. United States
c. New Zealand
d. all of the above
14. It is not clear if a consumption tax will lead to more saving because
a. it is unclear whether individuals will allocate their savings to tax-favored investments.
b. is not clear whether new savings funds are new savings or merely transfers from other accounts.
c. it is unclear if corporate taxes may lead to less efficient investment.
d. all of the above
15. A consumption tax is likely to benefit
a. corporations.
b. higher income individuals.
c. lower income individuals.
d. all individuals who consume a large portion of their income, regardless of income level.
16. Describe the phenomenon known as monetizing the debt and its relationship to inflation.
17. Can budget deficits be good for the economy? Explain.
18. Should the Fed focus on fighting inflation? What are the benefits and shortcomings of such a
proposition?
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19. The United States is a country with a low savings rate. Explain why. Also, some economists propose
that we move to a consumption tax rather than an income tax. Explain.
Answers to the Practice Quiz
1. d. The purchase of goods and services by the government and the transfer payments (Social Security,
welfare, and so on) it makes to its citizens are the government’s expenditures.
2. d. The government debt is the total of all of its yearly deficits.
3. b. Over the next decade, the Social Security portion of the budget is expected to run a surplus, but
over the longer horizon, as our society grows older, the surpluses will turn to deficits.
4. c. These are the government’s two options to finance the deficit.
5. d. The purchase by a central bank of newly created government debt is called monetizing the debt.
6. c. The government’s total debt is equal to its initial debt of $375 billion plus the sum of its subsequent
deficits ($75 billion + $125 billion + $100 billion). $375 billion + an additional $300 billion = $675
billion.
7. c. Ricardian equivalence is the proposition that it does not matter whether government expenditure is
financed by taxes or by issuing debt because everyone understands that higher debt will result in
higher taxes, so people save in anticipation of paying higher taxes in the future.
8. a. Nobel laureate James Buchanan has argued that people are less aware of government deficits than
the taxes they’re forced to pay, and this inevitably will lead to higher government spending and
bigger government.
9. d. Over short periods, deficits can help the economy to cope with shocks, such as oil price increases
or a collapse in the stock market. They give the government some room to maneuver out of a
recession. Deficits can also play a role in tax smoothing. Professor Robert Barro of Harvard
University has argued that it is more efficient to keep tax rates relatively constant than to raise them
sharply and then lower them later.
10. a. The method for arriving at a more comprehensive measure of a nation’s indebtedness was to
estimate the present value of the gap between the government’s revenues and expenditures and
adding it to the current national debt.
11. d. The costs of inflation include: Menu costs—the costs firms incur to change their posted prices; shoeleather costs, the costs individuals and firms pay for the time spent trying to reduce their holdings of
money; distortions in our tax and banking systems because inflation isn’t yet factored into them; and
arbitrary redistributions of money between debtors and creditors from unanticipated inflation.
12. a. The growth rate in nominal GDP equals the growth in real GDP plus the growth in prices
(inflation).
13. a. In the United Kingdom, it is ultimately the elected government that decides on the inflation target
for the central bank. In other countries, such as New Zealand, the central bank has the responsibility
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of “achieving and maintaining stability in the general level of prices” without any competing goals. In
the United States, the Fed has considerable power to use monetary policy to stabilize output as well as
to fight inflation as it pleases. But changing the current system to give Congress and the president
more power over monetary policy might lead to more inflation, not less.
14. b. It is not clear whether the funds are new savings—meaning reduced consumption—or merely
transfers from other accounts.
15. b. Since under a consumption tax saving would not be taxed, higher income individuals would tend to
benefit the most since this group tends to save the most as well as earn income from interest,
dividends, rents, and capital gains, which would also not be subject to a consumption tax.
16. Monetizing the debt is part of the debate about whether or not deficits lead to inflation. If the Federal
Reserve purchases the government bonds issued by the Treasury Department to finance the deficit,
that purchase creates money by taking debt out of the hands of the public in exchange for money.
Economists call the purchase by a central bank of newly created government debt monetizing the
debt. If a country has no options other than creating money to finance its deficits—in other words, if
the public is unwilling to buy its bonds, those deficits will inevitably cause inflation.
17. Yes, in some situations, deficits can be good for the economy. Over short periods, deficits can help
the economy to cope with shocks, such as oil price increases or a collapse in the stock market. They
give the government some room to maneuver out of a recession. Deficits can also play a role in tax
smoothing. Professor Robert Barro of Harvard University has argued that it is more efficient to keep
tax rates relatively constant than to raise them sharply and then lower them later. Thus, by running
deficits and only gradually raising taxes later to service the debt, we avoid creating excess distortions
in the economy.
18. Proponents of inflation targeting argue that the Fed should have only one primary goal: controlling
inflation. Commitment to a single goal would give the Fed more credibility and help to keep it free from
political pressures. Many other economists strongly object to having the Fed concentrate solely on
controlling inflation. There are legitimate questions about what constitutes “stable prices.” It is difficult
to isolate from prices changes the technological improvements that change the quality of goods rapidly.
Some economists like the idea of the Fed having to meet targets, such as to target the growth rate in
nominal GDP and thereby both the growth in real GDP as well as the growth in prices (inflation).
Critics of stabilization policy believe that attempts to stabilize the economy have done more harm than
good over the years by making fluctuations worse. Difficulties include lags, uncertainties about the
strength and timing of policies, and difficulties in estimating the natural rate of unemployment.
19. The United States is a country with a low savings rate. Colleges, welfare programs, and even the U.S.
tax system discourage savings. Tax systems based on consumption do not penalize individuals who
save. Sales taxes and value-added taxes are examples of consumption taxes. The key feature of a
consumption tax is that you do not face any additional taxes if you decide to save more of your
income. In practice, the U.S. tax system is a hybrid system: halfway between an income tax and a
consumption tax. Moving to a consumption tax system could have a major impact on the distribution
of income in the economy. If we exempt savings from the income tax, wealthy and high-income
individuals who save the most would clearly be favored.